Short selling on a rumor can pay on tall takeover tales

Opportunities to employ the strategy are increasing as mergers recover from the worst recession in more than 70 years, data compiled by Bloomberg show.

Tara Lachapelle, Bloomberg News

Published 10:46 pm, Friday, January 14, 2011

The surest way to profit from takeover speculation in the stock market is to bet it's wrong.

Electronic news services, brokerages and newspapers reported at least 1,875 rumors about potential buyouts of 717 companies from 2005 to 2010, according to data compiled by Bloomberg. A total of 104, or 14.5 percent, were acquired, the data show. Although stocks that were the subject of takeover speculation initially jumped 2.9 percent, betting on declines yielded average profits of 1.2 percent in the next month, an annualized gain of 14 percent.

Opportunities to employ the strategy are increasing as mergers recover from the worst recession in more than 70 years, data compiled by Bloomberg show. After bottoming in 2008, the number of unconfirmed stories about possible mergers surged 71 percent to 611 last year from 2009, data compiled by Bloomberg from more than 50 news providers and brokerages show.

"Sell into the strength," said John Orrico, who focuses on mergers and acquisitions at New York-based Water Island Capital LLC, which oversees about $2.2 billion. "We see it as an opportunity to sell if we think the rumor is false or ridiculous, which in most cases they are."

Short selling to speculate on declines on supposed takeover targets produced more than twice the average return generated by U.S. stocks, data compiled by Bloomberg show. At the same time, companies in the Russell 3000 Index had the same chance of being acquired in any 12-month period since 2005 as those that were the subject of merger stories, the data show. Stocks tracked by Bloomberg fell 0.2 percent, 0.6 percent and 1.2 percent on average in the day, week and month after a rumor report, Bloomberg data show. The S&P 500 rose 0.03 percent, 0.2 percent and 0.5 percent on average during the same periods.

The 14 percent annualized profit from short selling compares with a 6.2 percent yearly return since 1900 before dividends for U.S. stocks, inflation-adjusted data show. Short selling is the sale of borrowed stock in the hope of profiting by buying the securities later at a lower price and returning them to the shareholder.

Akamai Technologies Inc. has been the subject of more buyout rumors than any other U.S. company since the start of 2005. The provider of computing services that speed delivery of Internet content remains independent after being named 21 times.

The most recent instance was Dec. 16. After rallying 1.7 percent when the speculation was reported, shares of the Cambridge, Mass.-based company lost 3.8 percent in the next week as the S&P 500 gained 1.1 percent. A telephone call and e-mail to Jeff Young and Jennifer Donovan, spokesmen for Akamai, weren't returned.

"Don't chase rumor stocks," said Michael Vogelzang, Boston-based chief investment officer at Boston Advisors LLC. "You never know where you are in the chain, whether you're the first to hear it or the last. You're just playing with fire because you know if it doesn't work out, it's going to come down."

The shares fell 2.2 percent a day later, 9.4 percent a week later and 31 percent in 30 days.

"Netlist makes memory modules that go into servers, so Microsoft is not the type of company that would want to go and buy them," said Richard Kugele, an equity analyst at Needham & Co. in Boston. "There's a difference between hardware companies and software companies, and it's just completely outside the bounds of what they do."

By the time market chatter is publicly reported, it's been passed around trading desks via instant messages and e-mail and is usually old news, according to Todd Salamone, an equity analyst at Schaeffer's Investment Research in Cincinnati.

Profiting from the reports is impossible because shares have rallied, he said.

"I don't know where that stuff comes from," he said. "The rumors tend to create a pop, and eventually the fundamentals and technicals take over, especially in those situations that prove to be only rumors. It's a very short-term event."

Even when they coincide with other bullish signals such as increased options trading, rumors usually don't prove accurate.

Call volume in New York-based Jefferies Group Inc. jumped amid unconfirmed takeover reports on Feb. 27, 2008. Calls on the company changed hands 12,692 times that day, 24 times the four-week average and the most in almost a year, and the shares gained 3.7 percent. A deal never occurred and Jefferies dropped 3.4 percent the next day, 10 percent the next week and 20 percent in 30 days. The S&P 500 lost 4.7 percent in a month.

Some stocks eventually are acquired after years of buyout stories. Melville, N.Y.-based OSI Pharmaceuticals Inc. was the subject of takeover chatter nine times from 2005 to 2009, and the shares posted one-month declines averaging 9.1 percent.

Tokyo-based Astellas Pharma Inc. bought the company in June. OSI surged 52 percent March 1, after Astellas said it would begin a hostile takeover offer. There were no rumors on record in the days before that announcement.

"The question that remains unanswered is where does the takeover story originate," said Michael McCarty, managing partner at Differential Research LLC in Austin, Texas. "It's most likely from someone who's interested in selling."

Deliberately spreading false rumors may violate securities laws, especially if the intent is to sway prices, said James Cox, a professor at Duke University School of Law in Durham, N.C. Proving a market-manipulation case is difficult, according to Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.

"You might be able to see a unicorn before you see a market manipulation case established based on rumors," Henning said. "It's so difficult to pin down, and even if you can, to try to link them. You get lots of investigations announced and very few cases brought."

Many rumors are losers from the start. MetroPCS Communications Inc., the Richardson, Texas-based wireless network, lost 1 percent Sept. 21, 2009, after a news service reported unconfirmed chatter of a potential bid. Shorting the stock paid 34 percent over the next month. MetroPCS fell 49 percent in 2009, the fourth-biggest retreat in the S&P 500, data compiled by Bloomberg show. A call and e-mail to Diana Gold, a MetroPCS spokeswoman, weren't returned.

BioCryst Pharmaceuticals Inc. of Birmingham, Ala., surged 8.5 percent Nov. 4, 2009, amid takeover bets. While it jumped 13 percent the next day and 21 percent in a week, it posted a 25 percent slump through the beginning of December.

Short selling rumors "is not a bad strategy," said Mark Yusko, the Chapel Hill, N.C.-based president of Morgan Creek Capital Management LLC, which allocates about $10 billion to hedge funds. "The data confirms a lot of things that we've seen as we've gone through the last 20 years of information access and availability. As information has become ubiquitous, it is very difficult to separate the real information from the fake."